How does a yield-spread pickup trade differ froma credit-upside trade?

Question

What will be an ideal response?

Answer 1

A yield-spread pickup trade is characterized as a trade of an asset (such as a bond) for another like asset but with a higher credit spread whereas a credit-upside trade is characterized as a trade of an asset (such as a bond) for another like asset that is expected to havea credit upgrade. This upgrade will cause the asset to trade at a lower spread as opposed to a yield-spread pickup trade that is undertaken to increase the spread. Hence, for a credit-upside trade, profit can be realized without additional risk whereas the yield-spread pickup takes on additional risk to increase its yield. More details are found below.

A yield-spread pickup trade refers to the additional interest-rate spread an investor receives when selling a lowerinterest-rate spread in exchange for a higherinterest-rate spread. The bond with the lower spread generally has a shorter maturity, while the bond with the higher spread will typically have a longer maturity. A certain amount of risk is involved since the bond with a higher spread is often of a lower credit quality. Additionally, the investor can be exposed to interest rate risk with the longer maturity bond. The trade to pick up yield will not necessarily mean a superior expected return for the bond simply because of the higher spread. When the trade is undertaken, the portfolio manager must be sure that it is a dollar-duration-neutral trade so that the portfolio is not impacted by changes in the level of Treasury rates. Moreover, corporate bonds with different credit ratings will be impacted by changes in credit spreads and credit spread volatility as Treasury rates change.

A credit-upside trade refers to the potential dollar or percentage amount by which the asset could rise.We can illustrate a credit-upside trade as follows.Suppose that a credit analyst covering a particular sector within the corporate bond market believes a particular issuer will have a credit upgrade and is currently trading at a wider spread than what it would if the credit rating were upgraded. The action that might be taken by the portfolio manager to whom the credit analyst reports is to acquire the issue that is expected to be upgraded, assuming that the market has not reflected the anticipated action by the rating agency into the issue's price. Such a trade is referred to as credit-upside trade.